By Indexopedia Research Team | October 21, 2024 | In
Index investing has become a widely popular investment strategy in recent decades. Its origins can be traced back to the mid-20th century when financial pioneers introduced the concept of using market indexes as benchmarks for investment performance. Stock market indexes have been around for over 130 years, and over that time their role in the market has expanded dramatically. The initial use case of summarizing equity market performance morphed into benchmarking portfolio performance, and with the advent of index investing, became a mechanism to guide equity allocations. The evolution of index investing has transformed the way investors approach the financial markets and has had a profound impact on the investment industry as a whole.
The first stock market indexes were constructed and published in the late 19th century by financial newspapers as day-to-day summaries of stock market fluctuations. To our knowledge, the first daily index was published in 1884 by Dow Jones and Company’s Customer’s Afternoon Letter (the precursor to the Wall Street Journal). Under the name “Dow Jones”, it became the world’s most famous index.
The S&P 500 Index was initially introduced in 1923 and has been running in its present form since March 4, 1957. In 1984 both the FTSE 100 Index and the Russell 2000 Index were launched. FTSE Russell integrated their index services in 2015.
The first theoretical model for an index fund was suggested in 1960 by Edward Renshaw and Paul Feldstein, both students at the University of Chicago. While their idea for an “Unmanaged Investment Company” garnered little support, it did set off a sequence of events in the 1960s that led to the creation of the first index fund in the next decade.
John McQuown and David G. Booth of Wells Fargo, and Rex Sinquefield of the American National Bank in Chicago, established the first two Standard and Poor’s Composite Index Funds in 1973. The goal of these funds, according to Mr. Booth, was to “…bring academic rigor to finance”, referring to research showing many active managers failed to outperform their benchmarks. These funds were both established for institutional clients and were not open to individual investors.
In 1976, John Bogle (founder of The Vanguard Group) created the First Index Investment Trust as one of the first index mutual funds available to the general public. This fund was a precursor to the Vanguard 500 Index Fund, and gave access to the diversification and growth of index investing to the individual investor.
The growth of index investing has been driven by several factors. First, it offers a low-cost investment strategy, as index funds typically have lower expense ratios compared to actively managed funds. Second, index investing provides broad market exposure, allowing investors to capture the overall market’s performance rather than relying on the performance of individual stocks. Lastly, research has shown that a significant majority of actively managed funds fail to outperform their respective benchmarks consistently, further highlighting the appeal of index investing.
Direct indexing, often referred to as Institutional Direct, was developed upon the realization that index funds often fall short of maximizing an affluent investor’s outcomes. While offering small investors access to a diversified portfolio and a simplified way to invest, index funds often fall short in transparency, investor control, and the ability to tailor to an individual’s needs. Because investors are pooled, they have no control over their holdings. Unfortunately, due to herding, mutual fund and ETF investors are “along for the ride” with everyone else in the fund, even though their growth, risk, and tax needs, may be very different. So, where index funds leave off, direct indexing takes over.
Direct indexing was further refined by introducing earnings quality screens. While still using an index methodology to achieve broad market exposure, earnings quality screens allow the investor to exclude companies within the index that may not be financially healthy. This strategy gives the investor the potential to outperform a given index, without sacrificing diversification.
Today, index funds are very popular for small investors because of the ease and perceived benefits. However, affluent investors should consider direct indexing to maximize the benefits of an index strategy. Both direct indexing and pooled index funds harness the power of diversification while maintaining a simple, sustainable strategy.
